Forborne loans

What Are Forborne Loans?

Forborne loans refer to a temporary arrangement between a borrower and a lender where the lender allows the borrower to pause or reduce loan payments for a specified period due to financial hardship. This financial arrangement falls under the broader category of debt management, aiming to prevent a loan from going into default or foreclosure. During a forbearance period, the borrower typically does not make full payments, but the interest rate on the loan usually continues to accrue. This means the total amount owed can increase even while payments are paused. Forborne loans provide crucial, albeit temporary, relief, allowing individuals to stabilize their finances before resuming regular payments.

History and Origin

The concept of forbearance has existed in lending for a long time as a discretionary tool for lenders to work with borrowers facing temporary difficulties. However, the widespread adoption and structured nature of forborne loans gained significant prominence during major economic crises. A notable instance is the period following the 2008 financial crisis, which led to government programs like the Home Affordable Modification Program (HAMP). HAMP, launched in 2009 by the U.S. Departments of the Treasury and Housing and Urban Development, aimed to help struggling homeowners avoid foreclosure by modifying their mortgages and, in some cases, incorporating forbearance as a step toward sustainable payments.²⁵, ²⁶

More recently, forborne loans became a critical component of relief efforts during the COVID-19 pandemic. The Coronavirus Aid, Relief, and Economic Security (CARES) Act, enacted in March 2020, mandated forbearance for most federally backed mortgage loans and federal student loans.²³, ²⁴ This legislation provided an unprecedented pause on payments and interest accrual for millions of Americans experiencing economic disruption.²¹, ²² The CARES Act forbearance allowed eligible borrowers to temporarily suspend payments for up to 180 days, with the possibility of extensions, without additional fees or penalties.¹⁹, ²⁰

Key Takeaways

• Forborne loans offer temporary payment relief to borrowers experiencing financial difficulty.
• During forbearance, payments are paused or reduced, but interest typically continues to accrue, increasing the total debt.
• Forbearance is a temporary solution, and missed payments, along with accrued interest, must eventually be repaid.
• It is often used for mortgages and student loans, and was a key provision during the COVID-19 pandemic via the CARES Act.
• The terms of a forborne loan agreement are negotiated between the borrower and their lender or loan servicer.

Interpreting Forborne Loans

Forborne loans are a signal of financial strain for the borrower and a risk management tool for the lender. From a borrower's perspective, entering forbearance indicates a need for immediate relief to manage a temporary financial setback, such as job loss, medical expenses, or other unforeseen events. While it provides a crucial breathing room by pausing or reducing payments, it does not erase the debt. The goal of forbearance is to allow the borrower time to recover their financial stability, not to forgive the loan.

For lenders and financial institutions, identifying loans as "forborne exposures" is an important aspect of credit risk management. Regulators, such as the European Banking Authority (EBA) and the Bank for International Settlements (BIS), provide guidelines for classifying and managing forborne exposures to ensure transparency and proper assessment of asset quality.¹⁷, ¹⁸ These guidelines help determine whether a forborne loan remains a "performing" asset (meaning the borrower is expected to resume payments) or if it might transition to a "non-performing" status if the financial difficulties persist.

Hypothetical Example

Consider Sarah, who has a $200,000 mortgage with a monthly payment of $1,000. She loses her job unexpectedly and faces a severe financial hardship. To avoid defaulting on her loan, she contacts her mortgage servicer and applies for forbearance.

The servicer approves a six-month forbearance period, allowing her to pause her monthly payments entirely. During this period, the original $1,000 monthly payment is suspended. However, interest continues to accrue on her principal balance. If her interest accrues at, say, $500 per month, at the end of the six months, she would owe $3,000 in accrued interest in addition to the $6,000 in missed principal and interest payments.

Upon the conclusion of the six-month period, Sarah finds a new job. Her loan servicer works with her to determine a repayment plan for the accumulated $9,000. Options could include adding the missed payments to the end of her loan term, increasing her future monthly payments for a period, or making a lump-sum payment. This temporary relief allowed Sarah to avoid foreclosure and regain financial footing without immediately losing her home.

Practical Applications

Forborne loans are predominantly applied in situations where borrowers face temporary financial difficulties that prevent them from meeting their scheduled loan obligations.

• Mortgages: During economic downturns or personal crises, homeowners may seek mortgage forbearance to avoid foreclosure. This was widely seen during the COVID-19 pandemic, where the CARES Act provided broad mortgage forbearance options for federally backed loans.¹⁵, ¹⁶ Mortgage servicers work with borrowers to define the terms of the pause and subsequent repayment.
• Student Loans: Federal student loans frequently offer forbearance as an option for borrowers experiencing financial hardship, medical expenses, or unemployment. While payments are paused, interest often continues to accrue and may be subject to capitalization at the end of the forbearance period, increasing the total loan balance.¹³, ¹⁴
• Other Consumer Loans: While less common than for mortgages or student loans, some lenders may offer forbearance on auto loans, personal loans, or other forms of debt if a borrower demonstrates a genuine, temporary inability to pay. This is typically at the discretion of the lender.

The use of forborne loans can significantly dampen the negative financial impact on households during crises, as evidenced by research on the CARES Act's effects on the U.S. consumer credit market.¹²

Limitations and Criticisms

While forborne loans offer essential relief, they come with significant limitations and potential drawbacks for borrowers. The primary criticism is that forbearance is a temporary pause, not a reduction or forgiveness of debt. The accrued interest during the forbearance period can lead to a larger total amount owed, potentially increasing the borrower's future payments or extending the loan term. This process, where unpaid interest is added to the loan balance, is known as negative amortization in some forbearance arrangements.

For borrowers, exiting forbearance requires a clear plan to repay the deferred amounts, which can still be a significant financial burden. Options include a lump-sum payment, a repayment plan with higher monthly payments, or adding the missed payments to the end of the loan, which prolongs the debt.¹¹ Without a sustainable plan, borrowers risk falling into delinquency or default once the forbearance period ends.

Furthermore, while forbearance itself does not directly harm a credit score if agreed upon, subsequent difficulties in repaying the forborne amounts can negatively impact credit. For lenders, while forbearance helps avoid immediate defaults, prolonged or widespread forbearance can mask underlying asset quality issues, requiring careful prudential treatment and monitoring.¹⁰

Forborne Loans vs. Loan Modification

Forborne loans and loan modification are both debt relief options for borrowers facing financial difficulties, but they differ significantly in their nature and permanence.

Forborne loans are akin to hitting a "pause button" on payments, providing immediate relief for a brief period, with the expectation that the borrower will resume full payments and address the deferred amount later.⁹ Loan modification, by contrast, is a more fundamental restructuring of the loan agreement, aimed at creating a new, sustainable payment structure for a borrower who cannot reasonably afford the original terms in the long run.⁷, ⁸ A loan modification may involve lowering the interest rate, extending the amortization period, or even reducing the principal balance.⁶

FAQs

What happens to interest during forbearance?

In most cases, interest continues to accrue on the outstanding loan balance during a forbearance period. This means that even if you're not making payments, the total amount you owe is likely increasing. At the end of the forbearance, this accrued interest will need to be repaid, often by being added to your principal balance through a process called capitalization, or through a separate repayment plan.⁵

Will forbearance affect my credit score?

Generally, if you enter a forbearance agreement with your lender or loan servicer and adhere to its terms, it should not negatively impact your credit score. Lenders are typically required to report the loan status as current or as being under a forbearance agreement, rather than delinquent. However, if you fail to meet the terms of the forbearance or if the loan was already delinquent before entering forbearance, negative marks may appear on your credit report.⁴

How do I repay a forborne loan once the period ends?

The repayment options for forborne loans vary depending on the loan type and the lender's policies. Common options include a lump-sum payment of the missed amount, a repayment plan where the missed payments are spread out over a specific period by increasing future monthly payments, or adding the missed payments to the end of the loan term, which extends the overall life of the loan. It's crucial to discuss these options with your loan servicer before the forbearance period ends to create a clear plan.³

Can I get an extension on my forbearance?

The possibility of extending a forbearance period depends on the specific loan type and the lender's policies. For example, during the COVID-19 pandemic, federal programs allowed extensions for federally backed mortgages and student loans beyond the initial period.¹, ² For other loans, extensions are at the discretion of the lender and typically require a continued demonstration of financial hardship. You should contact your loan servicer well before your current forbearance period expires to inquire about extension options.